The Need for Comprehensive Social Security and Tax Reform and
Problems in the Government's Draft Proposal

Masatoshi Katagiri
Professor, Faculty of Economics, Chuo University
Areas of Specialization: Public Finance, U.S. Public Finance

1. The Need for Comprehensive Social Security and Tax Reform

The year 2011 turned out to be a tough one for the world and for Japan. In order to contend with the financial crisis and global recession stemming from the bankruptcy of Lehman Brothers in the fall of 2008, developed countries implemented large-scale fiscal stimulus and relaxed monetary policy. As a result, a crisis situation was avoided but with their economies not yet fully on a recovery path, the debt crisis in developed countries was exacerbated - evidenced in particular by the European debt crisis. In addition, the situation has brought a super strong yen to Japan. Rating agencies also downgraded government bonds of the countries with deteriorating fiscal positions one after another, and this practice has been continuing in 2012. Downgrading of government bonds naturally leads to higher long-term interest rates, thereby further deteriorating the finances and economy of a nation. Preventing such deterioration requires not only measures to counter the impending debt crisis but also fiscal consolidation.

Furthermore, developed countries face the challenges of aging societies and must establish social security systems that enable people to live with peace of mind. Moreover, while developed countries cannot hope for high economic growth, they are called upon to establish sustainable social security systems and at the same time to implement fiscal consolidation.

On January 6, 2012, the Democratic Party of Japan government officially decided on a draft proposal to promote comprehensive social security and tax reform as an urgent task, fearing that the nation's accumulated debt of 1,000 trillion yen would translate into a debt crisis with the additional burden of recovery from the Great East Japan Earthquake. According to the draft proposal, this reform aims at the simultaneous achievement of securing stable funding and a sound fiscal position in order to strengthen and maintain social security functions. Although the intention is agreeable, there are many concerns, which I will examine below.

2. Problems in the draft proposal for "Comprehensive Social Security and Tax Reform"

The outline of the draft proposal on "Comprehensive Social Security and Tax Reform" is shown in Chart 1. In the following section, I will point out four (4) issues of concern in the draft proposal.

Chart 1 Main Items of Comprehensive Social Security and Tax Reform

Taxation

- Consumption Tax Rate Increase
To raise the current rate from 5% to 8% in April 2014, and to 10% in October 2015. A single rate will be maintained, i.e., reduced rates for food, etc., will not be introduced.

- Increase of the highest marginal individual income tax rate (currently 40%)
To raise the tax rate for taxable income of more than 50 million yen to 45% from January 2015.

- Abolition of preferential tax treatment of securities transactions
To raise the tax rate for profits on sales and dividends of stocks (currently 10%) to 20% from January 2014.

- Strengthened enforcement of Inheritance Tax
To reduce basic deductions by 40% as well as to raise the maximum tax rate (currently 50%) to 55%.

- Refundable tax credits
To introduce after 2015 as the measure for low-income earners in conjunction with the Consumption Tax increase.

Pension

- Reduction of the pension amount kept constant at the time of price declines in the past to its legally prescribed level To gradually reduce the level by 2.5% in total from October 2012 to 2014.

- Expansion of the application of employees' pensions to nonpermanent employees

Implementation date to be determined

- Reduction of the basic pension for high-income earners by up to 33,000 yen per month.

- Lowering of the maximum amount of payment by low-income earners for expensive medical care

Implementation date to be determined

- Burden according to the capacity of each company employee to bear the cost of long-term care insurance.

Implementation date to be determined

Parenting support

- New parenting support system including the integration of kindergarten and nursery schools
Full introduction at the time of Consumption Tax increase.

Source: The Asahi Shimbun, January 7, 2012, morning edition.

(1) The draft proposal does not show a picture of the future social security system; for example, the specifics of fund-raising and system design for the new pension system - combination of earnings-related pension and minimum-guaranteed pension - and the New Medical System for the elderly aged 75 and over. Details of the system design for the priority areas of pension, medical service, long-term care service, and parenting are not yet determined, either.

(2) The conditions for a Consumption Tax rate increase could prove to be political hurdles in the course of realizing a Consumption Tax increase. The conditions are: (i) drafting the law based on consultation with opposition parties; (ii) checking economic indicators, such as growth rate and price movements, before raising the tax, with a clause for suspension of the tax increase in the draft law; and, (iii) trying to pass laws to reduce the number of Diet seats and salaries of national public servants.

(3) It is quite difficult to simultaneously achieve the securing of stable funding for social security and fiscal consolidation. In the Fiscal Management Strategy decided in June 2010, the government set a target that, as for the primary balance, the ratio of deficit to GDP shall be halved from that in FY2010 by FY 2015, and that the surplus shall be achieved by FY2020. Achievement of this target is difficult, however, because revenue from a Consumption Tax would be about 2 trillion yen less than the original estimation as the timing to increase the Consumption Tax rate to 10% would be delayed by half a year from April to October 2015. In addition, the Consumption Tax rate will have to be increased to around 15-17% in order to put the primary fiscal balance fully in the black; in other words, fiscal consolidation is extremely difficult.

(4) The draft proposal includes significant improvement in benefits relying on a prospective Consumption Tax increase, but on the other hand, the proposal postpones painful reforms. Some measures were originally planned but are not in the draft proposal; they include "fixed payment upon medical consultation," to ask additional payment from outpatients of 100 yen each visit, and an increase in payments at doctors' office - which have been kept at 10% of the total cost for people 70-74 years old - to 20%.

The substance of the draft proposal makes it clear that it is not a fundamental tax reform, but rather, it places Consumption Tax increase first while deferring fundamental issues. I will comment here on major taxes.

(1) The Consumption Tax Rate Increase and its problems

The Consumption Tax rate will be raised gradually, first to 8% on April 1, 2014, and then to 10% in October 2015. However, there is no explicit explanation as to why the rate will be 10% in 2015. In order to mitigate the regressivity of a Consumption Tax, lump-sum payments and refundable tax credits are proposed, but specifics are lacking, such as the size of the proposed measures or the threshold for low-income earners. Moreover, as for the introduction of an identification number system as a precondition, it is not clear how to prevent the invasion of privacy.

(2) The strengthened redistribution function of individual income tax/inheritance tax and its problems

It is proposed to levy the maximum marginal tax rate of 45% on high-income earners with income of more than 50 million yen from January 2015. This would, however, cover only 30,000 super rich people. Progressive taxation should be strengthened to be applied from income levels over 18 million yen. It is reasonable to propose that the basic deduction for the Inheritance Tax be reduced by 40 percent, and the highest marginal tax rate (currently 50%) be raised to 55%.

(3) The government's draft proposal has not specified concrete changes for Corporation Tax reform other than reducing the Corporation Tax rate by 5%.

The draft proposal for "Comprehensive Social Security and Tax Reform" advocates the simultaneous achievement of securing stable funding and a sound fiscal position in order to strengthen and maintain social security functions. It does not, however, layout a grand design for the social security system, it is ambiguous about mid- and long-term cost estimates, and securing necessary stable funding is difficult; therefore, the simultaneous achievement of fiscal consolidation is deemed difficult. In addition, it relies almost entirely on revenue from the Consumption Tax, and it remains merely tax reform that places the Consumption Tax increase first while deferring fundamental issues. We need to promote a real Comprehensive Reform of Social Security and Tax.

Masatoshi Katagiri
Professor, Faculty of Economics, Chuo University
Areas of Specialization: Public Finance, U.S. Public Finance

From Osaka Prefecture. Born on August 15, 1945.
Graduated the Department of Philosophy, Faculty of Letters, Kyoto University, in 1969.
Graduated the Department of Economics, Faculty of Economics, the University of Tokyo, in 1972.
Worked for Toshiba Corporation and Others.
Finished a doctoral course at the Graduate School of Economics,Tokyo University, in 1980.
Obtained a Doctorate in Economics from the Graduate School of Economics,Tokyo University, in 1992.
Served as Associate Professor at Sapporo Gakuin University as well as Associate Professor and then Professor at Tokyo Keizai University before taking up current position in 1996.
Standing Director of the Japan Institute of Public Finance and Editor-in-Chief of the Institute's Serial Publication, Fiscal Studies [Zaisei kenkyu], and board/committee member of many other academic societies.
Visiting Researcher at American University in FY1993-94 and 2003.
Visiting Researcher at London School of Economics in FY2004.
Received the 10th Fujita Prize from the Tokyo Institute for Municipal Research in 1984 for the research on public finance in U.S. metropolises.
Research on intergovernmental fiscal relations among federal, state, and local governments in the U.S., research on U.S. tax policy, international comparative study on public finance of welfare states, and study on tax and public finance in Japan.
Sole author, Structural Change in U.S. Public Finance-Realignment of Intergovernmental Fiscal Relations among Federal, State and Local Governments [Amerika zaisei no kozo tenkan-renpo/shu/chiho zaisei kankei no saihen], Toyo Keizai Inc., 2005.
Sole author, Theory of Formation of intergovernmental administrative and fiscal relations between federal and city governments-New Deal and Public Finance in Metropolises [Amerika renpo/toshi gyozaisei kankei keiseiron-nyu deiru to daitoshi zaisei], Ochanomizushobo CO., LTD., 1993.
Co-editor, Public Finance-Japanese Public Finance in Transition-(2nd edition) [zaiseigaku-tenkanki no nihon zaisei (dai 2 han)], Toyo Keizai Inc., 2007.
Co-editor/author, New Developments in Decentralized Public Finance [bunkenka zaisei no sin tenkai], Chuo University Press, 2007
Co-editor/author, New Developments in Globalized Public Finance [gurobaruka zaisei no sin tenkai], Chuo University Press, 2010.